If you want to grow your money, investing is one of the best ways to accomplish that. But along with more earnings come higher taxes. Investment taxes are one aspect of investing that you need to understand if you want to keep more of your money. Benzinga has outlined some of the most common investments and offers you tips about how to minimize the amount of taxes you will owe when tax season hits.
Types of Investment Taxes
You can find many places to invest your money, and as someone who wants to grow your wealth by investing the funds you have, you need to understand how taxes will affect your profits. When you have a good understanding of what an investment is and how you can minimize your taxes as you earn, you will set yourself up for success.
Here are six types of taxes you can expect to pay on your investments.
1. Dividend Taxes
When you hold stock as a shareholder, the company can issue dividends. Those dividends are taxable, but the taxes you pay will depend on what type of dividend they are. There are two types of dividends: qualified and nonqualified.
A qualified dividend meets certain requirements of the Internal Revenue Service (IRS) such as being a U.S. company or a foreign company that meets IRS requirements. This type of dividend is taxed at the lower long-term capital gains tax provided that you meet the required holding period. For instance, you must hold the stock for 60 days or more during the 121-day period that starts 60 days before the ex-dividend date. That date is typically one day before the record date. Shareholders pay rates of 0%, 15% or 20% for qualified dividends, depending on their filing status and income.
A shareholder who is issued a nonqualified dividend pays the same tax rate as their ordinary income tax rate. A nonqualified dividend does not meet the above requirements. Some examples of nonqualified dividends are employee stock options; dividends paid on money market accounts, credit unions or banks; dividends paid by real estate investment trusts (REITs); dividends from tax-exempt companies; or dividends paid by Master Limited Partnerships (MLPs). The tax rate for nonqualified dividends is the same as the federal tax rate: between 10% and 37%.
To minimize the taxes you pay on dividends, you can do the following:
- Strive to only invest in qualified dividends.
- Take all the legal deductions you can so that you will fall into a lower tax bracket, reducing the amount of dividend taxes you are required to pay.
- Place your dividend earnings into a retirement account or a college savings account to eliminate or defer the need to pay taxes on them.
2. Capital Gains Taxes
Capital gains taxes are taxes on the profits you made from the sale of an asset. For example, if you sell stocks, land or a business, you may profit from it and, in most cases, have to pay taxes on it. The IRS defines two types of capital gains: long-term capital gains and short-term capital gains.
Long-term capital gains are gains made on an asset that you have held for one year or longer. For instance, if you sell stocks that you bought two years ago, you will pay long-term capital gains taxes on them. For these types of taxes, you will pay a 0%, 15% or 20% tax rate on the profit you made from the sale, depending on your filing status and your income.
Short-term capital gains are the profits that you earn from selling an asset that you have owned for less than a year. For instance, if you started a business nine months ago and sold it after ten months, that would be considered short-term capital gains. You will pay the same taxes on this type of profit as you do for your ordinary income. In other words, if you are in the 22% tax bracket, you will pay 22% taxes on the short-term capital gain.
One way to reduce the amount of taxes you pay on capital gains is with tax-loss harvesting. When using this method, you offset your gains by losses on other investments. For instance, if you had a capital gain of $6,000 in stock sales and lost $3,000 in other stock sales, you would only have to pay the capital gains tax on the $3,000 profit when using this method.
3. Mutual Fund Taxes
A mutual fund is a fund where many investors contribute money and that money is invested in stocks and/or bonds by a professional. The shareholders pay an annual fee for the management of the fund. You may owe taxes on mutual funds whether you keep the fund or sell it. In other words, there are three types of taxes for people who invest in mutual funds.
First, you may owe taxes on the dividends or interest that you earn on the mutual fund while you own it. No matter whether you receive the monies from the dividends or interest or choose to reinvest it in the fund, the IRS considers the income taxable. You will pay the same rate as you do on your ordinary income for this type of investment. The only exception is if the fund is invested in U.S. Treasuries or municipal bonds – they may be considered tax-free earnings.
Next, if the fund manager sells securities in the fund and makes a profit, you will have to pay taxes on your share regardless of whether you take the profit or reinvest it in the fund. These types of sales typically happen once a year. You will pay capital gains taxes on these profits and the tax rate depends on whether you have held the investment short-term or long-term.
Finally, when you sell your shares in the fund, you will owe the IRS taxes on your profits. This process can become complicated because, if you’re like most people, you bought a few shares at a time. When it comes time to sell, you have three options in how you calculate your profit. You can designate the exact shares that you bought and at what price, you can sell the oldest shares that you own first or you can use an average cost of all of your shares. It’s best to speak with an accountant when deciding which method will save you the most on taxes.
To minimize the taxes you pay when receiving earnings from mutual funds, try to hold on to the fund for more than a year if doing so fits with your investment strategy and risk tolerance. This practice will allow you to use the long-term capital gains tax rate and save you money on your taxes.
4. 401(k) Investment Taxes
You don’t have to pay taxes for the money you place into a Traditional 401(k) investment that year. That’s why many people use these investment vehicles for their dividends and other earnings that they want to defer taxes on. But once you withdraw the money from a traditional 401 (k), you will pay the same tax rate as you do on your ordinary income. And if you withdraw the money from the account before you reach 59 ½., you will also have to pay a 10% penalty fee.
If you choose to invest in a Roth IRA, the money is taxed at the rate you pay for your ordinary income at the time you put it into the account. Then, when you withdraw your qualified distributions, you will not have to pay tax.
To reduce the amount of taxes you pay on your 401(k) investments, be sure to understand the age requirements for distributions.
5. Home Sale Taxes
When you sell a home, you may have to pay capital gains taxes on the profits that you made from the sale depending on several factors. If any of the following are true, you will have to pay capital gains on the profits that you earn from the home sale.
- The house you sold was not your primary residence.
- In the five years before you sold the house, you owned it for less than two years.
- You did not live in the house for at least two years in the five years before selling it. (If you are disabled or in the military, foreign service or the intelligence community, you may be exempt from this rule.).
- You sold a home in the previous two years and claimed an exclusion.
- You are required to pay expatriate tax.
- You purchased the house in a 1031 exchange in the past five years, which is an investment tool that allows you to swap out one type of property for the same type without paying capital gains tax.
If none of the above applies to you, you may qualify for an exclusion that will allow you to forego paying capital gains tax. If you are single, you can exclude up to $250,000 on capital gains. For instance, if you sold your home for $500,000 that you had bought for $200,000 and earned a profit from the sale of $300,000, you could exclude $250,000 from the profit and only pay capital gains on $50,000.
The amount of tax you will pay depends on whether you owe short-term capital gains taxes (assets owned for under a year and the same tax rate as your ordinary income) or long-term capital gains taxes (assets owned for more than a year and depending on your income, are taxed at 0%, 15,% or 20%, depending on your filing status and income.)
If you are married and filing jointly, you can exclude up to $500,000 of the profit.
The best way to minimize the taxes you will pay when you sell your home is to live on the property for at least two out of five years. If it’s an investment property and you don’t live in it, consider making use of the 1031 exchange to avoid the capital gains tax.
6. Net Investment Income Tax (NIIT) Taxes
For both qualified and nonqualified dividends, you may owe an additional tax called the net investment income tax (NIIT) if you meet certain income levels. If you are single and have a modified adjusted gross income of more than $200,000, you could owe this tax. Likewise, if you are married and filing jointly with an income of more than $250,000, you could need to pay the tax. The NIIT applies to both qualified and nonqualified dividends as well as realized gains. It is at 3.8% in 2022.
Why Hire an Accountant for Investment Taxes?
Hiring an accountant for investment taxes can help ensure that you’re making the best use of your money and keeping more of it in your pocket. Here are some of the benefits of hiring an accountant when dealing with investment taxes.
- They understand the tax code: Whether you are deciding to use a 1031 exchange when selling a property or need to understand how to best set up a retirement account to accept your dividend payments, an accountant can save you a lot of money by advising you based on their knowledge.
- Dividend expertise: When buying dividends, you want to ensure that you purchase qualified dividends that will allow you to pay fewer taxes. An accountant familiar with dividends can help ensure that you purchase qualified dividends and avoid making a costly mistake.
- Tax loss harvesting: Offsetting capital gains is a complex endeavor, and if you plan to make use of tax loss harvesting to offset your gains, a qualified accountant can help ensure that you stay within the legal boundaries while still maximizing your tax savings.
Compare DIY Tax Software
Now that you understand some of the tax implications for your investments, you should take a look at some DIY tax software options. Benzinga reviewed tax software and outlined the comparisons below.
TurboTax by Intuit is one of the best free tax software for simple returns. The Deluxe Version ($59) will maximize your deductions and credits, the Premier Version ($89) is for people with investments and rental properties and the Self-Employed Version ($119) is for people who own businesses. TurboTax is one of the easiest tax software to use.
Cash App Taxes (formally Credit Karma Tax) is an easy-to-use platform that is best for people who want to file on their phone or computer. It is completely free no matter how complicated your taxes are.
TaxSlayer offers several options for taxpayers. The TaxSlayer Classic is ideal for any tax situation and costs $29.95. The TaxSlayer Premium costs $49.95 and is also ideal for any tax situation, but it includes access to tax professionals. The TaxSlayer Military is free, no matter the type of tax situation. The TaxSlayer Simply Free is for those people who only need to file a simple 1040 and it is, as its name implies, completely free. Finally, the TaxSlayer Self Employed is for those who own a business and may need to file both W2s and 1099s, and it costs $59.95.
Frequently Asked Questions
How much tax do you pay on investments?
The amount of tax that you pay on investments depends on the type of investment. For instance, if you fall into certain income brackets, you may not have to pay any taxes on dividend income at all. And if you meet the exclusion requirements for a home sale, you may be able to exclude up to $500,000 in profits depending on your filing status.
How can I avoid paying taxes on stocks?
To avoid paying taxes on stocks, you have a few options. You can use a tax-advantaged retirement account to hold the profits, you can use tax-loss harvesting where you deduct tax losses from your tax gains to reduce the amount of profit you owe taxes on or you could take every legal tax deduction allowable so that you fall into a lower income tax bracket.